Page 523 - Introduction to Business

CHAPTER 14 Understanding the Financial System, Money, and Banking 497

ered a benchmark interest rate. Other short-term interest rates in the money
market are likewise affected by federal funds rate movements. Through the federal
funds rate, the Fed maintains direct control of money market rates.
The causal link between policy tools and broader monetary and economic goals
(shown in Exhibit 14.4) is less direct. Key monetary goals are the intermediate intermediate targets The primary
targets of money supply, long-term interest rates, and bank credit. A number of monetary targets in the financial
marketplace, which are money supply,
market forces can weaken the Fed’s control over these monetary goals. For exam-
long-term interest rates, and bank
ple, while higher demand deposits immediately increase M1, the effect on M2 credit
(small savings deposits of consumers) and M3 (large savings deposits of business
firms) can be delayed for some months. Also, bank credit may not expand as much
as anticipated in the transactions deposits equation due to other factors, such as a
slowdown in the economy. Additionally, changes in money market (short-term)
rates should affect capital market (long-term) rates, but the timing is difficult to
precisely predict. The Fed might push down money market interest rates in an
attempt to stimulate firms to borrow money and get the economy moving in a
period of recession. However, in times of recession, many firms do not want to bor-
row money due to low sales revenues. Firms will not increase borrowing until they
feel confident that sales revenues are increasing. In this case monetary policy tools
and related operating targets are less effective than would be desired by the Fed as
it seeks to jump-start the economy and stimulate increased credit and output. The
dynamic aspects of these events make the amount and timing of policy tool
changes uncertain to some degree. Of course, the Fed is constantly monitoring the
effects of using policy tools on operating targets and their delayed impacts on mon-
etary as well as economic goals.
Economic goals are the final outcomes of monetary policy, including produc- economic goals The aims of monetary
tivity (or output growth), employment, stable prices (or low inflation), and interna- policy, including productivity,
employment, stable prices, and trade
tional trade. The news media regularly reports information on gross national
product and industrial production as common measures of productivity. Unem-
ployment rates, inflation rates, and export and import figures are frequently men-
tioned in the news also. Importantly, from the equation of exchange, we know that
money matters in the sense that it can affect productivity in the economy. Stimu-
lating productivity normally tends to increase jobs and trade.
Sometimes the economic goals of output, full employment, stable prices, and
international trade can conflict with one another. As an example of economic
trade-offs, higher inflation normally means less unemployment, whereas lower
inflation is associated with higher unemployment. We would prefer to have both
lower inflation and lower unemployment, but these economic goals often trade off
against one another. Thus, if the Fed implements monetary policies to lower infla-
tion, it could do so at the cost of higher unemployment.
International trade and finance can conflict with other economic goals also. If
the Fed uses a higher interest rate to slow down business activity, because currency
values and interest rates tend to be inversely related to one another, the value of the
U.S. dollar would fall over time. The lower value of the dollar would stimulate
exports by U.S. firms. For example, suppose that Volkswagen in Europe wanted to
purchase steel from the United States. As the U.S. dollar falls, European buyers can
purchase more steel per euro than previously. In effect, the prices of U.S. goods and
services fall in foreign currency terms. Increased production in the United States to
meet rising export demand would offset to some degree the negative effect of
higher interest rates on slowing production by U.S. firms. These and other potential
conflicts in monetary and economic goals suggest that the Fed must prioritize com-
peting goals and regularly monitor progress in achieving key goals.

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